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How Much Liquidity Insurance Can Lines of Credit Provide? the Impact of Bank Reputation and Lending Relationship*

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How Much Liquidity Insurance Can Lines of Credit Provide? the Impact of Bank Reputation and Lending Relationship* How Much Liquidity Insurance Can Lines of Credit Provide? * The Impact of Bank Reputation and Lending Relationship Zhaohui Chen McIntire School of Commerce University of Virginia Yan Hu University of Minnesota Duluth Connie Mao Temple University Current version: February, 2011 JEL Classification: G21, G32 Keywords: Lines of credit, liquidity insurance, bank reputation, lending relationship, moral hazard. * Zhaohui Zhen, McIntire School of Commerce, University of Virginia, Charlottesville, VA 22903. Tel: (434) 243- 1188; Email: [email protected]. Yan Hu, Department of Finance & MIS, Labovitz School of Business and Economics, University of Minnesota Duluth, Duluth, MN 55812. Tel: (218) 726-7083; Fax: (218) 726-7516; Email: [email protected]. Connie X. Mao, Department of Finance, Fox School of Business and Management, Temple University, Philadelphia, PA 19122. Tel: (215) 204-4895; Fax: (215) 204-1697; Email: [email protected]. We would like to thank Lalitha Naveen, David Reeb, Elyas Elyasian, Warren Bailey, and seminar participants at University of Virginia and University of Minnesota Duluth for their helpful comments and discussions. All errors are solely ours. How Much Liquidity Insurance Can Lines of Credit Provide? The Impact of Bank Reputation and Lending Relationship Abstract Theories suggest that firms use lines of credit as a liquidity insurance to secure a desirable investment level in the event of future downturn (Holmstrom and Tirole,1998; Tirole, 2005). In this paper we examine the liquidity insurance hypothesis by directly quantifying the extent of insurance that a line of credit provides and shed light on how bank reputation and prior lending relationship help a credit line to supply more efficient liquidity. Consistent with the liquidity insurance hypothesis, we find that firms are more likely to use credit lines at times of poor performance, and the drawdown rate is on average significantly lower than the imputed market cost of borrowing given the firm's financial condition at the time of drawdown. In addition, we document that the strength of prior lending relationship is associated with a lower drawdown rate. Furthermore, the impact of prior lending relationship on the drawdown rate only exists for borrowers subject to greater information asymmetry. While borrowers are penalized (paying a higher loan spread and annual fee and more likely to pledge collateral) on new lines of credit issued after their drawdown, the penalty is smaller as they borrow from higher reputation banks. Our results suggest that bank reputation and prior lending relation both help provide a more efficient liquidity insurance, however through different channels. 1. Introduction A line of credit is a bank's promise of future lending sold to a borrower.1 The borrower may draw down at any time prior to maturity, up to the maximum amount, paying interest at a pre-determined spread over LIBOR or prime rate specified by the agreement. Lines of credits are the most popular form of bank lending, representing 80% of commercial loans in the United States (Duca and Vanhoose 1990).2 According to FDIC (www2.fdic.gov/SDI), outstanding unused lines of credit of U.S. corporation amount to $1.7 trillion at the end of 2004. The literature offers two hypotheses for why firms use line of credit. One is the convenience hypothesis, under which a credit line assures a firm a certain level of funding in the future. This convenience is valuable if the firm faces uncertainty about its funding needs. An example is when the firm is exploring acquisition opportunities in a timely fashion.3 The other hypothesis is the liquidity insurance hypothesis. A line of credit can provide funding so that a firm can take positive NPV project when the firm cannot otherwise get financing due to frictions in the financial markets. For example, Holmstrom and Tirole (1998) and Tirole (2005, 2010) argue that in the absence of a line of credit, a firm may have to forgo positive NPV projects in a future downturn. This is because after the firm gives the minimum cash flow from the project to the entrepreneur to motivate him to work hard, there is not enough left-over cash to be pledged to 1 Borrowers usually pay a upfront fee as well as an annual commitment fee for the option to access liquidity. 2 In the Dealscan data, 63% (or 73%) of loans are lines of credit based on the number of loans (or the amount of loans). These number increases to 82% (or 86%) in our sample that are present in Compustat and CRSP, and tend to be larger firms. 3 Lins, Servaes, and Tufano (2010) analyze survey data collected from CFOs of public and private firms in 29 countries and document that 60% of firms view that lines of credit provide certainty of funding during event risk or acquisition opportunities, and 32% of firms indicate that the time to raise funds is an important consideration as they use lines of credit. 1 the investors to raise the necessary funding for the project.4 Note that these two hypotheses are not mutually exclusive. The existing empirical evidence suggests a limit to the liquidity insurance hypothesis. Campello, Giambona, Graham, and Campbell (2010) find that firms that are more likely to need lines of credit (small, private, noninvestment grade, or unprofitable) have less access to credit lines than their large, public, investment-grade, profitable counterparts. Sufi (2009) finds that lines of credit are reduced when a firm‟s liquidity level is low. If the purpose of a line of credit is to insure a firm against liquidity shock, why is it withdrawn when the firm most needs it? A bank has at least two ways to renege on a line of credit commitment: renegotiate regarding credit line terms such as loan rate, or revoke the entire loan commitment if the firm‟s financial condition worsens by invoking the Material Adverse Change (MAC) clause.5,6 Given the lender's many options to escape the commitment, to what extent, if any, does a line of credit provide liquidity insurance? The first goal of our paper is to address this question. First, we examine the difference between the loan rate at which a firm draws down a line of credit and the rate the firm could obtain in the lending markets at the time of drawdown. The extent of liquidity insurance would be measured by the difference between the drawdown rate and the market lending rate. We find evidence supporting the liquidity insurance hypothesis: on average the drawdown rate is about 25 basis points lower than the imputed market rate given the firm‟s financial condition. For firms with a strong prior lending relationship with the bank, the drawdown rate is 63 basis points lower 4 See also Boot, Thakor, and Udell (1987, 1991) and Berkovitch and Greenbaum (1991) for other frictions that a line of credit can mitigate to reduce under-investment problem. 5 Roberts and Sufi (2009) show that over 90% of long-term debt contracts are renegotiated prior to their stated maturity. Renegotiation leads to significant changes the maturity, amount, and spread of the contract. Less than 18% of renegotiations are directly or indirectly linked to a covenant violation or payment default. 6 Most loan commitment contracts include a MAC clause, which permits the bank to decline to lend under the commitment if the borrower‟s financial condition has declined significantly since the commitment was sold. 2 than the imputed market rate. On the other hand, we find that the drawdown rate is higher than the contract rate, indicating renegotiation between the firms and banks and/or performance pricing determine the drawdown rate. Furthermore, more than 50% of the lines of credit in our sample are drawn down, suggesting that line of credit provides economically significant liquidity insurance to the firm. Finally, consistent with the insurance hypothesis, a firm is more likely to draw down when it experiences a negative shock as measured by ROA or violations of debt covenants. If a line of credit provides insurance to a firm experiencing a financial downturn, it is subject to the classic moral hazard problem extensively studied in the insurance literature (for example, Rothschild and Stiglitz, 1976). More specifically, the firm may be less careful in avoiding a financial downturn because a credit line guarantees access to relatively cheap financing.7 For lines of credit to add value, they must feature mechanisms that motivate borrowers to behave appropriately. One such mechanism in the literature is future punishment (Radner, Myerson, and Maskin, 1986; Atkeson and Lucas, 1995). More claims filed by the insured would lead to a higher premium in the future. We study this type of mechanism by investigating whether borrowers tend to be punished in the future after drawing down a line of credit. We find that a drawdown leads to higher rates and greater collateral on future lines of credit. These results hold after we control for the firm‟s characteristics at the time when the new line of credit is granted. This result supports the liquidity insurance story. An alternative form of punishment, denial of any future new line of credit, is inefficient in that it not only hurts the firm but also the bank because the bank loses business. We find that banks seldom use this form of punishment of drawdown firms. 7 Alternatively the firm may undertake negative-NPV projects to take advantage of the cheap financing as shown by Holmstrom and Tirole (1998). 3 Both borrowers and lenders are subject to moral hazard problems in their management of lines of credit. As mentioned previously, the bank can renege on its commitment and the firm can take higher risk to exploit the liquidity insurance the bank provides.
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